Three Common Trading Mistakes

Trading is a lot like dating: often you have to make enough mistakes and suffer the consequences when you don't have much on the line before you start making good decisions when you're playing for keeps. Here are some of those bad dating experiences that I find developing traders make with markets, preferably when they're not risking too much of their capital:

1) Short circuiting their process - Most traders develop a "process": a way of looking at market data and gathering information in order to generate promising trading ideas. For the scalper, that process is quicker--with faster-moving data--than for the investor; each has his or her own cognitive style and preferred information sources. When traders short circuit their process, often in order to catch a move under way or avoid a normal adverse price excursion, they tend to make decisions reflexively, on the basis of superficial data and processing. That often makes them part of the herd, and markets don't reward that over time. A great example is getting out of a winning trade prematurely (before it hits its price target), with the idea of "I'll get back in at a better price later". When the better price doesn't materialize, the short-term gain pales beside the missed opportunity. Another great example is rationalizing a losing trade by turning it, on the fly, into a longer-term position.

2) Failing to become aggressive during winning trades - This is something I've noticed about very good traders: it's not so much that they have so many more winning ideas than their peers. Rather, they have a keen sense for when they're right, so that they can scale into those profitable moves. This is different from chasing a move, and it's different from adding to losing trades; they will patiently wait for the market to retrace, and then they'll add to the trade. The losing trader will be threatened by the retracement and will be thinking of exiting altogether. The aggressiveness that led to the trade isn't sustained during the trade. As a result, the average size of winning trades is not so different from the average size of losers over time, limiting overall performance.

3) Easing up after winning periods - When I review trading results with a trader, I like to identify winning stretches and then see how the trader made decisions after those periods of profitability. Many times, the trader will alter how they trade due to overconfidence or just plain sloppiness. Sometimes they'll start trading with more risk, trading more frequently, or trading with less preparation at the start of the day. Successful traders bear down when they see markets well to take full advantage. Many times they'll ask me to make sure that they don't let up. When traders stop doing what has made them successful--particularly when they're telling themselves that they've finally broken through--that's when they're most vulnerable.

I see where SSK is posting "brief therapy" video snippets to supplement his series on "a great day trading". The idea is to use review to highlight your mistakes and turn those into "therapy" goals, even as you review your "great days" and stay in touch with your strengths. Your three common trading mistakes may be quite different from the above list. The key is to know where you can best improve your performance--and then turn that information into a directed program for self-improvement.
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High Yield, Low Performance and Other Market Ideas

* Unyielding Yield Play - One rule that's held consistently in the recent market is that reaching for yield has cost investors in performance. I took a look at the FINRA data and the numbers were eye-opening. Here are the advance/decline numbers this past week for bonds in their investment grade index and bonds in their high-yield index (in parentheses):

Tuesday, Nov. 18th: 1611/1232 (347/639)
Monday, Nov. 17th: 1374/1422 (317/650)
Friday, Nov. 14th: 1540/1140 (401/555)
Thursday, Nov. 13th: 1379/1471 (360/631)
Wednesday, Nov. 12th: 1607/1390 (334/728)

As we can see, advancing bonds and decliners have been pretty even for the last five trading days among the investment grade issues. Decliners have been ahead of advancers by about 2:1 among the high-yield bonds, however.

Significantly, we had 266 out of 3211 investment grade bonds traded on Tuesday make fresh 52-week lows, less than 10% of the group. Among high-yield bonds, 285 of the 1118 bonds traded made new annual lows, more than 25% of the group. Bond pricing is an excellent sentiment gauge, when you consider that pricing is reflecting perceived odds of default.

* Twitter Update - You may have noticed that I'm adding more blog links to my Twitter posts; I'll also be tracking daily money flow figures for the Dow, with some observations about flow numbers specific to market sectors. Subscription to the Twitter postings is free, of course; you can sign up on my Twitter page or simply track the last five posts on the blog under "Twitter Trader".

* Blog Traffic - We hit new lows today; the market was really ugly throughout the session. Still, I'm not seeing the expansion of blog traffic the way I did during the October routs. Over the weekend, the numbers were more consistent with levels seen at market tops, as I noted in a Twitter post. It's not a perfect measure, but it's held up pretty well during this period of weakness.

* Free Webinar - Dave Mabe of StockTickr is speaking at the Las Vegas Traders Expo tomorrow, and his talk on automated trading will be webcast free of charge. Sweet.

* Lots of Good Reading - Fresh links from The Kirk Report, including a look at sector P/E ratios and more trouble ahead from derivatives.
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Under Pressure: Insurance Stocks and Commercial Mortgage Backed Securities

While banks have received much of the attention among financial stocks, life insurers have come under particular pressure of late. The insurance index ($KIX; top chart) reached a new bear market low on Monday, thanks to unusually weak performance by MET, PRU, and others.

Meanwhile, concerns over defaults in the commercial mortgage space led to a widening of spreads for even the most creditworthy tranches of commercial mortgage backed securities (CMBS; bottom chart). Many insurers are highly exposed to the commercial real estate market; those default fears mean that insurers are moving opposite in price to those CMBS spreads. Indeed, we've even seen a tripling in the cost of default insurance for blue chip insurer Berkshire Hathaway in the past two months. Should commercial real estate markets continue to crumble, we could see further price pressure on the insurers--and yet more calls for rescue funds from the government.
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How Volatile Is This Stock Market?

I went to the cash S&P 500 Index from 2003 through June of 2007 and calculated that the median weekly high-low price range was 2.09% (mean 2.32%).

I then looked at the *daily* high-low range for $SPX from July, 2007 to the present and found that the median was 2.63% (mean 3.58%).

The discrepancy between the mean and median for the recent daily time period indicates that we have had a number of outlier, high-volatility days that have skewed the average upward. This skew was less pronounced during the earlier period.

Bottom line: a single day's trading range in the S&P 500 Index is at least 30% larger than a week's trading range from 2003 to mid-2007. When we consider those outlier days, we're getting an average of 50% more volatility per day than we used to get in an entire week.

That has real implications for the sizing of positions and the need for tight risk management. As we saw late this afternoon, an hour in the present market can make all the difference in terms of entries and exits.
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Stress and Performance in Trading

An excellent review of research by Mark Staal, conducted for NASA, offers fascinating windows on the variety of ways that stress can affect human performance. Examining hundreds of research studies, the author finds that stress interferes with attention, memory, decision making, and perceptual motor performance. His review questions the common notion that people perform better under moderate loads of stress than under very low or very high levels. Rather, in many spheres, there is an inverse linear relationship between experienced stress and performance.

The behavioral finance literature suggests that one reason stress might affect performance among traders is by skewing their assessments of risk and reward. Under pressure, traders may narrow their cognitive scope to only the information most salient to them (availability bias) or relevant to their expectations (confirmation bias); focus only on superficial qualities of observations (representativeness heuristic); or become more likely to take profits than losses (disposition effect). In other words, stress disrupts performance by altering normal, sound information processing.

In a unique study, Lo and Repin found that veteran traders are less likely to experience the physiological effects of stress in response to market events than novice traders. A reasonable interpretation of the results is that, through repeated experience, traders learn to psychologically normalize the stresses associated with the risks, rewards, and uncertainties of financial markets. Directed training, in which traders rehearse sound decision making under particularly stressful market conditions, could greatly accelerate a trader's learning curve. Indeed, this is a model of training central to the development of many professionals in performance fields, from military special forces to the surgical sub-specialties.

A major flaw of much trader education is that it is not applied under conditions of stress, and so cannot train the trader to perform flawlessly in the heat of battle.
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The Vote of No Confidence Among Financial Stocks

To date, government efforts have focused on stabilizing the financial sector, including banks and insurance companies. From the above charts, it seems safe to say that the stocks of these financial firms have not responded favorably to these rescue efforts. The financial stocks within the S&P 500 universe (XLF) has lost 2/3 of its value and are hovering at bear market lows (top chart). As the helpful chart from Decision Point illustrates (bottom chart), the advance-decline line specific to financial issues within XLF is steadily moving to bear market lows. We're also seeing unusually negative money flows from the XLF stocks.

It is difficult to imagine sustaining a bull move in stocks overall without seeing some signs of investor confidence in this key sector. At this point, XLF may be serving in part as a sentiment gauge regarding investor confidence in the government's rescue efforts. Thus far, the verdict is thumbs down.
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Indicator Update for November 17th

Last week's indicator review noted, "Unless and until we can pierce that level with some decisive breakouts among the indicators, I view this as a range market and expect further testing of market lows." We did indeed get that testing of lows on Thursday morning, followed by a vigorous afternoon rally, and then by a swoon on Friday. By the end of the week, the various S&P 500 sectors remained in a downtrend, with money flow negative on the week and a weak advance-decline line for NYSE common stocks.

The Cumulative Demand/Supply measure (top chart) remains moderately oversold, and we're coming off of expanded new 65-day lows (middle chart) among NYSE, NASDAQ, and ASE stocks on Thursday. Each selloff since October has resulted in fewer stocks making new 65-day lows, but we have also been unable to sustain periods in which new short-term highs have outnumbered new lows. This lack of buying interest is reflected in the Cumulative NYSE TICK line (bottom chart), which has been falling steadily through the week.

So that's the dilemma: while recent selloffs have not been as broad and sustained as in early October, neither are we yet getting indications of sustained buying interest. Until that occurs, it is premature to assume that a durable intermediate-term bottom is in place. The followthrough to Friday's weakness--whether we can hold Thursday's lows--will tell us a great deal about how much firepower the bears retain.
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Trending Markets and the Volume Weighted Average Price (VWAP)

Brian Shannon has nicely described how the volume-weighted average price (VWAP) serves as an institutional measure of value for the trading day. VWAP builds during the day, with price weighted by the volume traded at that price. As a result, an uptrending market that is attracting volume from buyers will show a smoothly rising VWAP. During such an uptrend, price will remain above VWAP and will build distance above it. Conversely, in a downtrend that is attracting volume from sellers, we will see a steadily falling VWAP. Price will remain below VWAP and will build distance below it.

We can think of VWAP as the market's emerging estimate of value for the trading day. Thus, where we trade relative to VWAP tells us whether we are shifting value to the upside or downside. In the chart above, we can see that crossovers of VWAP told us we were not trending on the day. On range days, we will oscillate above and below VWAP; fading those moves for a return to value becomes a successful trade.

Much of intraday trading consists of recognizing when we are escaping the orbit of value/VWAP to the upside or downside and when we are bound to its gravitational pull.
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Cumulative New Highs/Lows and Stock Market Trends

One way to define a trend is a period in which more stocks are making new highs than new lows. I've taken new 20-day highs and lows across the NYSE, NASDAQ, and ASE going back to 2002 and created a cumulative line from the data. When the (pink) line is rising, we have a period in which new 20-day highs are outnumbering new 20-day lows. When the line is falling, new lows are dominating.

At times of transition, we see a handoff between new highs and lows. When the market made a momentum low in October of 2002 (top chart), the cumulative new high/low line also made a low. This was followed by a significant rally in which new highs meaningfully outnumbered new lows. When stocks retested their lows in March of 2003, the cumulative new high/low line did not confirm.

The reverse was the case at the 2007 market top. We saw new 20-day highs consistently outnumber new lows into the momentum peak at mid year (middle chart), then a topping and meaningful pullback of cumulative new highs/lows, followed by price highs in October that were not confirmed by the cumulative high/low line.

As we struggle to hold recent lows in the S&P 500 Index (bottom chart, blue line), the cumulative new high/low line continues to march to new lows. So far, we see no non-confirmations on the order of the two trend reversals illustrated above.
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Sector Update for November 15th

Last week's sector update found that the eight S&P 500 sectors that I follow had turned bearish in their short-term trending. Here's how we're looking at the end of this past week, based upon the Technical Strength measure.

MATERIALS: -320
INDUSTRIAL: -200
CONSUMER DISCRETIONARY: -240
CONSUMER STAPLES: -160
ENERGY: -140
HEALTH CARE: -120
FINANCIAL: -300
TECHNOLOGY: -300

We can see that, despite volatile moves to the upside and downside this past week, the trending behavior of the sectors is pretty similar to last week. While we've seen short bursts of impressive short covering/buying, we haven't yet been able to turn that into a sustained uptrend. As of the close on Friday, only 13% of SPX stocks were above their 20-day moving averages, according to Decision Point. One reflection of the market's weakness this past week: on Thursday, 155 out of the 500 S&P stocks made fresh 52-week lows. That remains lower than the 228 lows registered in late October and much lower than the over 400 (!) SPX lows that we saw in the second week of October.
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Conflict and Creativity in Trading Performance

As part of elaborating a cognitive perspective on trader performance, I recently took a look at the role of creativity in trading. From this vantage point, idea generation can be described as a two-part process of observation and analysis followed by comparison and synthesis. The creative insight occurs when observation and analysis lead to contradictory conclusions, requiring a fresh perspective that bridges these contradictions.

Let's take an example that has occurred many times over in my work with portfolio managers and traders. Suppose I am working with an active trader while he is trading; he is intently watching the market and trying to make sense of what he is seeing. The market moves within a relatively narrow range near the highs for the day session. Once, twice, three times the trader starts to click on a price to enter a buy order, only to pull back. It looks as though support is holding and an upside breakout is imminent, but every time the S&P 500 futures tick up, they run into a wave of selling from market makers. The NASDAQ futures move to a marginal new high for the day...once again the trader is ready to buy...the bank stocks still look weak...the trader is glued to the screen.

Suddenly, the trader exclaims, "This thing is ready to collapse!" Not enough volume could eat through the modest offers resting above the market and suddenly there is a pulling of bids. "That's what happened yesterday!" the trader explains, recalling a similar intraday decline. He quickly sells the futures before a flood of sell orders hit the market, waits for the futures to take out an obvious near-term support level on increased volume, and covers his position into the selling.

What we see in such an example is a careful process of observation and analysis initially leading to contradictory conclusions. During the tension of this contradiction, the trader is caught between competing impulses. Then a fresh set of observations leads to a new perspective: the way in which orders were entered and pulled near a resistance level brought to mind the previous day's market. That similarity reorganized the trader's thinking and led to the creative insight that the market was about to collapse. No longer trapped in contradiction, suddenly possessed of clarity, the trader is able to act decisively.

An important implication of this cognitive account is that many problems of trading performance are the result of a breakdown in the creative process. Effective creativity seeks contradiction; it thrives on dialectical tensions and resolutions. This tension, however, is not comfortable--and it does not come naturally. As we know from behavioral finance research, some of the most common trader and investor shortcomings are confirmation biases and disposition effects that lead us to avoid short-term discomfort. We look for evidence that supports our positions; we sell winners for quick gratification and hold off on selling losers to avoid pain.

Many of the most successful portfolio managers I've worked with are quite insightful about their process of idea generation. They know what to read, who to talk with, and how to process information to get to the point of "Aha!" Most market participants, however, are only dimly aware of how they generate good ideas for trading and thus cannot standardize how they think across situations. Imagine a factory that changed how it produced goods based on the ups and downs of daily sales: quality control would go right out the window. Traders, however, will shift their processes from hour to hour, day to day in ways that they don't recognize.

Much coaching of traders helps them think about performance. Some of the most effective coaching, however, helps traders think about their thinking and understand the processes that they utilize to make sense of markets.
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The Role of Creativity in Trading

In my last post, I sketched preliminary ideas regarding a cognitive theory of trading performance. One important implication of such a theory is that declines in the performance of traders and portfolio managers may not simply reflect "discipline" problems in the face of emotional pressures. Rather, a host of internal and environmental factors may conspire to shift market participants out of their optimal modes of processing information.

How does one generate an idea for trading or investment? I propose that this is a two-step process in which observation and analysis is followed by consolidation and synthesis. In the ideal trade, a number of observations relevant to markets and market participants come together and crystallize as a core idea or theme. Traders are familiar with the feeling of "rightness" that accompanies a gratifying synthesis: suddenly, out of the welter of data, there is clarity. It all comes together, and the trader experiences an intuitive "feel" for what is likely to happen.

Readers will recognize this as a creative process, not unlike the creativity of scientists. After many observations of nature, a scientist will generate a model that is the basis for a theory. Many times, this model will spring from an insight derived from an analogy. The behaviorist B.F. Skinner, for instance, drew upon evolutionary thinking to explain how reinforcements select for certain behaviors and not others, resulting in learning.

The "models" created by traders may not be so elaborated or even conscious. They can take the form of an image of what is likely to happen or an idea of a theme integrating recent observations. We build such models according to our native modes of information processing. In each case, however, the model-building--the idea generation of the trader--is a synthetic process. It may unite fundamental information, information derived from price and volume, information from related markets, recent news, or some combination of the above. Synthesis is a fundamentally creative process, because it extracts fresh order and meaning from what is given.

Problems can occur in trading at many points in this analysis/synthesis process. We can fail to make market observations, simply out of an impulsive need to trade. We can make those observations, but then fail to make the shift to a mindset that facilitates synthesis. Many active traders underperform because they act before observation/analysis has an opportunity to crystallize in a creative insight.

An interesting article summarizes research into some of the factors that facilitate and interfere with creativity. One important conclusion from this work is that fear and time pressure hinder the creative process. "Time pressure stifles creativity because people can't deeply engage with the problem," the article notes. "Creativity requires an incubation period; people need time to soak in a problem and let the ideas bubble up." The competitive, fast-paced conditions that are present in much of the trading world don't naturally lend themselves to incubation. The active mindset needed to gather observations may not be the mindset necessary for integrating those observations into market insights and unique trading ideas. Traders, after all, can only be as good as the ideas they act upon.

More on this topic in the next post in the series.
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Toward a Cognitive Theory of Trader Performance

We tend to think of trading ideas and positions in terms of their objective characteristics: the market traded, the location of the trade, its direction, the size of the position, the target, etc. This can have the result of making any one trade look similar to others when a trader behaves in a disciplined fashion. It becomes confusing to the trader why some seemingly good ideas work out and others don't.

Suppose, however, we think of trading in subjective terms: how ideas present themselves to the trader. For example, some ideas are experienced by the trader primarily as subjective hunches and felt tendencies; other ideas may be expressed as explicit, planned ideas. Still other ideas can manifest themselves as images: pictures of what the trader thinks will happen. Yet other ideas take the form of analogies and metaphors, sometimes drawn from other markets, other times from entirely other spheres of experience.

Moreover, traders in the same market, looking at the same data (technical, fundamental, etc.) may process this information quite differently. Just as we have unique combinations of personality traits, we also possess distinctive cognitive styles.

Where fear, greed, overconfidence, stress, risk, and uncertainty may affect performance is by nudging traders out of their normal, effective cognitive styles. Under duress, a conceptual trader may act impulsively on a hunch. An intuitive trader might overthink markets. The trader who reasons in images or metaphors may become too detail oriented, analyzing where they should be synthesizing.

This suggests limitations to the usual coaching of traders, which tend to focus on strategies and feelings, not the cognitive path by which ideas are generated and expressed as trades. Traders may enter slumps, not because of market dislocations or psychological stress alone, but because of subtle and unrecognized shifts in how they process information.

A cognitive framework for thinking about trading performance strikes me as uniquely promising and fits well with my observations of hedge fund portfolio managers. In my next post on this topic, I'll offer a specific example and elaborate some of the implications of this view for self-coaching.
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Tracking The Recent Stock Market Weakness

As the helpful chart from Decision Point illustrates, we're testing the October lows in the NYSE Composite Index (top pane), but we're already making fresh bear lows on the advance-decline line specific to NYSE common stocks only (bottom pane). Meanwhile, we had 1208 stocks make fresh 65-day lows across the NYSE, NASDAQ, and ASE, which is only about half the number that we saw in late October and less than a fifth of the number we saw during the second week of October.

With Wednesday's broad decline (declining stocks led advancing issues by over 2600 issues on the NYSE), the forty stocks in my basket (five highly weighted issues from each of eight S&P 500 sectors) have turned distinctly bearish. Only one stock is showing a neutral short-term trending mode on my Technical Strength measure; the remaining 39 are in downtrends.

While the non-confirmations to date from the new highs/lows and Cumulative NYSE TICK are enticing for bottom-fishers, the weakness among the S&P 500 sectors and the advance-decline line show us in a strong short-term downtrend. We've had some sharp upward bounces during the trading days this week, but the buying interest has not been sustained. We now need to see selling interest and momentum dry up at the range lows if this is indeed to be part of a bottoming process. To date, that drying up has not occurred.
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Self-Coaching and The Sound Training of Traders

As we saw in the recent post, sustaining sound decision making during the heat of battle can be a major challenge for traders. Many traders try to correct that situation by writing in journals or simply by vowing to do things differently the next time. When the next time arrives, however, they are in a completely different state of mind and body and end up making the same mistakes. Working on decision-making under stress while you are cool and calm is not effective; you can't learn to operate under pressure unless you rehearse proper trading practices while you are under pressure.

This is why sports teams scrimmage as a form of practice; why military troops drill under battlefield conditions. If there is a single principle that governs sound training, it is this: rehearse skills under progressively realistic conditions. Talking with coaches does not, in itself, change traders. What changes traders is the right kind of experience in "the heat of the battle". Training builds trader mindset; no amount of mind games--in Olympic sports, elite military, chess, or performing arts-- can substitute for learning by doing.

When you are functioning as your own trading coach, you are also acting as your own trainer. You are creating a directed program to train yourself to perform more effectively under given sets of emotional and market conditions. This is why so many traders fail to change their behaviors, despite the best of intentions. They operate as if a coaching session--with self-talk or journal entries--can correct their problems, when what they really need is an ongoing process of training.

So how do you train yourself to operate in the heat of trading? A very effective technique is to dedicate at least 15 minutes each day before the start of trading to guided imagery work. In this exercise, you recreate in your mind as vividly as possible actual situations that have triggered your worst trading behaviors. For example, let's say that missing a market move has triggered frustration for you, leading you to chase trends and execute trades with very poor risk/reward. You would want to keep yourself relaxed and focused, sitting still and breathing deeply and slowly, while you vividly imagine missing a market move.

The key word in the above is "vividly". You want to picture the market running away from you without your being on board. You want to imagine the frustration you feel in that situation and the thoughts that go through your head. Most of all, you want to summon that feeling of wanting to jump into the market to make the money that you missed out on. All the while, during this imagery work, you are keeping yourself physically still and calm, with the help of deep breathing.

This is where I find biofeedback to be especially helpful. When you're connected to a biofeedback unit, you can actually monitor your body's level of arousal, so that you're able to keep yourself cool physically, even as you're mentally rehearsing scenarios under the heat of battle. (I will post a biofeedback linkfest to the new blog shortly, for readers who are interested in making use of this technology).

Once you've been successful in recreating those thoughts and feelings associated with your problematic trading, you want to imagine just as vividly how you would like to respond to those situations. So, for example, if perfectionism is leading you to feel pressure because you missed a market move, you would want to visualize yourself feeling the desire to jump into a "revenge" trade, reminding yourself that this has lost you money in the past, stepping back from the screen, telling yourself that there is plenty of future opportunity, patiently waiting for your next setup, and executing that next trade with a clear mind and favorable risk/reward.

What you're doing with the above exercise is training yourself to stay calm, focused, and disciplined while you're immersing yourself in stressful trading scenarios. The key to success is repeating this exercise, varying the details of the scenarios, every day before you start trading until the thoughts and behaviors you're rehearsing become second nature. It's not at all unusual for this to take a month of daily work, devoting at least 15 quality minutes to the exercise. Remember: this is training and no one trains themselves for performance events overnight. The time you devote to reprogramming your responses to trigger situations, however, is an investment that will yield impressive returns throughout your trading career.
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Becoming Your Own Trading Coach Blog

Most readers are probably aware that I started a new blog in support of the Trading Coach book that will be coming out in the first quarter of 2009. Over time I'll be developing the new blog into a resource collection for traders interested in the psychological aspects of trading performance.

Here are a few recent linkfests from the Trading Coach blog:

Trading Discipline Linkfest

Learning to Trade Linkfest

Self-Coaching Linkfest

I will be adding resources to the new blog periodically, including supplementary material to update and elaborate the new book.
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Staying Cool in the Heat of the Battle: A Key Skill for Active Traders

So often in my meetings with active (intraday) traders, I hear the phrase "in the heat of the battle." Usually what follows that phrase is a description of some trading mistake: trading too aggressively, ignoring risk guidelines, deviating from planned ideas, etc.

The problem is not that traders make these mistakes; we all do at times. Rather, the problem is that the mistakes become compounded "in the heat of the battle". Once traders are caught up in that heat, they lose the ability to recognize what is going wrong. They also lose their perspectives on markets.

Heating systems in homes have thermostats that control temperature. When the room becomes too cool, heat kicks on. When the room becomes warm, the heat turns off. Many active traders lack an emotional thermostat. They don't know their temperatures. They are like heating systems that get the room hotter and hotter, until the house is unbearable.

One of the core ideas from The Psychology of Trading--and perhaps one of the most important ideas I've ever put forward--is that many of the problems that affect traders are state-specific. How traders think and behave is relative to the states of mind and body that they are experiencing at the time. The reason that coaching (and self-coaching) often doesn't work is that we are in one state of mind and body when we are analyzing and working on our problems and in a completely different state when we are experiencing the triggers that set off those problems.

This explains the common experience that traders have when they look back on their day's performance and wonder, in amazement, how they could have made such rookie mistakes. In a normal frame of mind, they wouldn't have acted so rashly. In "the heat of the battle", they become a different person; they process information differently.

Few challenges are more important to active traders than the ability to develop an emotional thermostat. But talking with a coach, writing in a journal, or vowing to oneself that next time will be different won't touch the problem. As my earlier book stressed, you can only solve the problem by entering the state that is specific to that problem and then reprogramming your patterns of thought and behavior.

My upcoming book will have much to say on this topic, with specific exercises. In my next post in this series, I'll outline a specific strategy that has helped me and many of the traders I've worked with.
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A Few Thoughts About Traders and Trading

I spent the day in Chicago meeting with traders; here are just a few thoughts from those meetings:

* Risk Management - If you lose 10% of your trading account, you need to make 11.1% on the remaining capital to get back to even. If you lose 20% of your account, you need to make 25% on the remaining capital to return to breakeven. At a 30% loss, you have to make 37.5% to become whole; at 40% loss, you have to make 67% to return to even. Once you've lost half your trading capital, you need to double the remainder to replenish your account. Much of trading success is limiting losses and avoiding those fat tails of risk.

* What is a Trader? - If you ask a trader what is a good market, he will tell you that it's a market that has good volatility; a good market is one that moves. If you ask an investor what is a good market, he will tell you that it's a rising market. Lots of people try to succeed as traders with the mindset of investors. It doesn't work.

* Refutation - The story goes that Samuel Johnson, upon hearing Bishop Berkeley's theory that objects existed in mind only, kicked a rock in front of him, announcing, "Thus I refute Berkeley!" The incident came to mind when I met with a trader today who trades very actively every day, has made money on more than 80% of days this year, and has made several million dollars this year. His performance was clearly documented by his firm and the firm's risk manager. Thus he refutes efficient market theory.

* Success - When I see traders like the one above (quite a few at his firm are up more than a million dollars this year), it's an inspiring reminder that success *is* possible to those who work diligently at trading as a career. The support of a superior firm doesn't hurt, either.
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Indicator Update for November 10th

Last week's indicator review noted considerable strength among the indicators, overbought readings, and resistance around the 1000 area of the S&P 500 Index. After some continued strength early in the week that briefly took us above that 1000 region, very strong selling hit the market for two consecutive days before a bounce on Friday left us pretty much in the middle of the wide range defined by the October lows and the recent price highs. As I noted in that earlier review, until I observe signs of breakout or breakdown among the indicators, I continue to view this action as part of a bottoming process that started with a momentum low around October 10th.

We continue to see signs of buying interest in the Cumulative Adjusted NYSE TICK line and a downward trend in the number of stocks making fresh 20-day lows. Overall, however, the majority of stocks within the major S&P 500 sectors are in short-term downtrends. We have come off very overbought levels in the Cumulative Demand/Supply Index (bottom chart) and finished on Friday at relatively neutral levels. While we've seen a reduction in the number of issues making new 65-day lows (top chart), we have not yet seen a meaningful expansion of 65-day highs, given the sharp market decline of the past few months.

The advance-decline lines specific to the S&P 500 large cap stocks and the S&P 600 small caps are off their late October lows, but also off their recent highs after the strong two-day selloff. That 1000 region of the S&P 500 Index remains important resistance; we saw plenty of sellers enter the market when we hit that mark. Unless and until we can pierce that level with some decisive breakouts among the indicators, I view this as a range market and expect further testing of market lows.
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Learning to Trade: Viewing Yourself, Reviewing Your Trading

In a recent post, I emphasized that much of the development of trading expertise is a function of pattern recognition and the ability to act upon patterns promptly in real time. A classic example of performance by pattern recognition is the development of competence and expertise among radiologists. Reading an x-ray or other form of imaging means being able to detect normal variations from abnormal ones. In the beginning, to the untrained eye, most medical images will look alike. Only with repeated exposure to images and their variations will medical students learn to make and rule out diagnoses. No amount of book work can substitute for learning at the bedside and reviewing film with experienced physicians.

The trader who video records his or her trading has a powerful tool for accomplishing three learning tasks:

1) Seeing more market patterns and cementing those more firmly in mind;

2) Reviewing performance to assess areas of trading that need more work and to formulate goals for such work;

3) Reviewing performance to assess areas of trading that represent strengths, so that these can be crystallized and recruited during future trading.

When I left my full time work with proprietary traders in Chicago and began working with bank and hedge fund traders, I was surprised by the sophistication of the latter group in terms of portfolio management and equally surprised by that group's utter lack of feel for short-term market movement. Many times, a portfolio manager would describe an excellent idea to me and then execute it at the absolute worst time of day. I realized that, as savvy as the institutional traders were, they lacked the frequency of exposure to short term market patterns and hence had no real "feel" for when buyers or sellers were dominating (or losing their dominance) from minute to minute, hour to hour.

Traders who use video recording in essence double their exposure to market patterns--and to their own patterns as traders. Because pattern learning is a function of the number of repeated exposures to various configurations, the trader who not only views markets, but also reviews them, is more likely to enjoy an accelerated learning (and performance) curve.

The two most common means of recording that I've encountered in my work with traders is desktop video (software that records your screen) and actual video recording with a camcorder pointed at the screen. The former is available through programs such as Camtasia; the latter is best accomplished with a camcorder that includes a large hard drive.

Of course, it doesn't make sense to review the entire trading day, every trading day. In general, the best reviews come from your best trades and your worst: those will cement what you do right and what you need to improve. If traders only reviewed their single best and worst trades each day--what the markets did and what they did--I suspect they would be more likely to achieve competence, and would do so in less time than the trader who packs it in at the market close.

Remember, however, research suggests that it is not just what you review but how that makes all the difference in learning. The most powerful learning takes observations and turns them into concrete goals for future observation. Passive watching of markets (and one's own performance) is much less powerful than active watching and goal setting.
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